Book review – Deep Risk by William Bernstein

Today, we review an important book by William Bernstein – Deep Risk: How History Informs Portfolio Design.

William is a renowned writer who covers Asset allocation, practical tips for DIY investors and economic history. All his books are fascinating reads and Deep Risk in particular covers an aspect which is crucial to us at Fundexpert – Asset protection.


First of all , William defines risk in real, crisp terms, which is scary for anyone invested in the capital markets.

Risk = size of real capital loss times * duration of real capital loss.

Mistiming the markets, by buying high and selling low, is the most common method whereby an investor sees this risk manifested in their life, as this is the best way to experience a permanent loss of capital.

Bernstein then identifies two “flavors” of risk:

Shallow risk and deep risk:

Shallow risk is the loss of real capital which recovers within several years. Shallow risk is important and can be expected to arrive on a somewhat frequent basis, but it can be managed by having sufficient liquidity and discipline to stay-the-course in the face of investing storms.

Deep risk reflects the permanent loss of real capital. It could be defined, for instance, as a negative real return over a 30-year period. Deep risk, on the other hand, is a much wilder beast. Over time, it is permanent losses of capital which defines risk, and it becomes apparent that stocks are risker than bonds with respect to shallow risk, but that the opposite is true with respect to deep risk. Throughout the world in the twentieth century, fixed income investors have suffered permanent losses in inflationary storms which equity investors were able to avoid.

Challenges for planners:

For lifetime financial planning, determining how to transition between deep risk and shallow risk at different points in the lifecycle is one of the greatest challenges every wealth manager/ financial planner faces.

Forbes has covered the book in great detail. We’ll highlight a few things from it, which caught our eye.

The Permanent Portfolio:

In 1970, Harry Brown, having lost his trust in Wall Street devised the Permanent Portfolio. This was a canonical landmark for investment strategists and his Permanent portfolio is the world’s best known investment strategy.

The Permanent Portfolio seeks to provide a sound structure and disciplined approach to asset allocation. The Fund was born in an environment where investors didn’t know where to turn.

Harry states the inevitable “It’s easy to think you know what the future holds, but the future invariably contradicts our expectations. Over and over again we are proven wrong when we bet too much on our expectations. Uncertainty is a fact of life.” No one can accurately predict the future.

He would hold one asset that would shine in each of the four possible future economic scenarios: prosperity (stocks), inflation (gold), deflation (long bonds), and recessions (cash).  Brown held 1/n or 25% of each asset.  This assured him that he at least had one pony in play no matter which scenario happened.

permanent portfolio

Permanent portfolio

1.Prosperity is good for stocks and bonds.

2.Recession is good for cash.

3.Deflation is good for bonds and cash.

4.Inflation is good for gold.

And since you can’t really predict which of those conditions will prevail at any time, why not buy all the asset classes in equal proportions? Some will go up while others go down, but the part that goes up tends to push the whole portfolio higher. The Permanent Portfolio seeks to increase volatility in each asset class in order to achieve stability across the whole portfolio. This zigging and zagging among the assets typically cancels out and translates into a steady rate of overall growth…. Only total portfolio performance matters.

For example, in the US, gold was the only asset class to post a positive real return in the inflation-racked 1970s and also led the field during the lost decade of the 2000s. But it did terribly in the two-decade-long bull market of 1980-1999, when stocks and bonds set the pace. The Permanent Portfolio is good for most people – young, semi-retired or retired.

But, it’s by no means perfect. Bernstein introduced three vital considerations into the equation: the historical probability of each scenario, the likely severity of the consequences, and the cost of insurance.

Bernstein’s 3 considerations of the 4 economic conditions:

His analysis of the 4 economic conditions of Harry Brown coupled with his 3 considerations resulted in the following. The cheapest insurance is international diversification of your portfolio. Gold is a much better hedge in deflationary scenarios than during inflation.  Cash holds up.  Long-term Treasuries perform spectacularly, but get crushed by inflation (which is far more probable), making them an expensive insurance.

Financial history suggests that in the long run, the most probable threat to your long-term wealth is inflation, and that although stock returns can do poorly in the short term with inflation, in the long run they’re usually an effective store of value–quite probably better than gold or other commodity strategies.  Bonds, on the other hand, are hurt badly by inflation, in both the long-term and short-term. Therefore, he says, he’d be very wary of any strategy that overweights bond allocations.

According to William, the following are the probabilities for each of the 4 economic conditions:

  1. Inflation – high probability, low cost of protection.
  2. Deflation – least probability, high cost of protection.
  3. Confiscation – medium probability, most of us don’t fall into this bracket.
  4. Devastation – low probability and can recover.

Deep risk

Buying in a rock bottom market:

In 1932, when US stocks had fallen by 90% no one had any money to buy them. People who had a chance to pick stocks for throwaway prices didn’t enjoy it one bit. Most stock market rock bottoms feel this way. Those with real guts to buy stock at such ridiculously low prices, would have no money to buy and those who had been cautious all along and had saved money would have no risk appetite to buy in such a downturn.

The brain and risk management:

The brain does a great job at risk management when we are trying to cross the street. But it does not seem particularly suited to evaluating the probabilities of  distant threats. The answer to this lies in how the brain evolved. Human risk management behavior evolved over tens and hundreds of thousands of years, when the greatest threats tended to be very short term; on the plains of the Serengeti, the ability to react quickly to a flash of black and yellow stripes in the visual periphery carried real survival benefit.  In modern society, by contrast, we need to plan for risks and threats that are decades in the future, and those sorts of instinctive reactions are downright dangerous in dealing with long-term problems such as retirement, education, life-style choices, and so forth.

William’s final words are “maintain a prudent portfolio balance so that you’ll be able to survive any scenario”. Whether you get rich or not, please don’t die poor, he says.

About the author

Subha Viswanathan

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